By James Beadle from Market-Melange
Markets fluttered earlier this week when Jim O’Neill of Goldman Sachs suggested that China might revise its exchange rate policy. Plenty have speculated about this topic, and even O’Neill admits that the prospects are far from clear.
However, Jim was responsible for coining the BRIC acronym, and few westerners have a better grasp of the world’s fastest growing major economy, so his thoughts are well worth considering. It is particularly interesting that he is suggesting that China might follow a policy route similar to that which Russia is currently developing. So, let’s take a look at what Russia can tell us.
Russia’s Shifting Central Bank Policy
For a long-time in the last bull market, the ruble was a one-way bet. At the behest of a strong industrialist lobby (ministers and regulators also chair large state-owned companies) the government and central bank held the ruble artificially weak, allowing only a gradual appreciation. Spurred by rising oil prices, the ruble crept from nearly 32 versus the dollar in mid 2003, to 23.3 in mid 2008. Yet, partly as a consequence of currency undervaluation, Russian CPI ran wild at the same time, reaching more than 15% YoY in mid 2008.
Russian CPI – Strengthening the Case for Policy Change
Then the tide turned, and Russia famously blew some $200 bln preventing a ruble rout and allowing Russian corporates to manageably cover their FX debt risks.
Even before the crisis began, the CBR had expressed intent to shift FX policy to target inflation. This had proved tough given the power of the industrial lobby, which argues that Russia needs a weak exchange rate to compensate for high business costs (bureaucracy and corruption) and inefficient, out-dated equipment.
But, the direction of the currency turned when oil fell and investors fled during the Georgia war, and this enabled the central bank stepped up its political campaign, widening the ruble trading band – as we observed at the time on MM.
The CBR was now explicit about its strategy – going forward the currency would be granted greater volatility, which it hoped would increase the risks and reduce speculative tendencies. Exactly the policy that O’Neill perceives may come about in China.
Does It Work?
The top chart, which shows the ruble versus the dollar and 30 day annualized volatility, shows clearly that the currency has indeed become more volatile since mid 2008. To some extent, the central bank can claim victory then. Yet, the success of the policy is far from clear.
The ruble is dominated by one macro factor: the price of oil. Since oil prices are cyclical, the ruble has a natural tendency to flow in medium- to long-term waves. As fate would have it, price of oil has been relatively stable over the past few months, helping ruble volatility to increase. Even so, the stickiness of oil prices above the government’s own projected prices has given the ruble an upward bias.
Oil Price Dynamics
But, such flat oil prices are not a long-term phenomenon, and as cyclicality returns to Russia’s key export, so the ruble will rapidly find its trading band too tight, and once more become a one-way bet (be it up or down), highlighting the limitations of this strategy.
This raises a question as to whether or not this gradual shift to currency flexibility is actually good idea. Here, I would have to answer yes. True, it is not going to stop speculation, which moves more quickly than fundamental cycles. But, if it is implemented persistently over time (and we have yet to see how successfully the central bank can allow ruble strengthening should the commodities bull market resume) then it should force the steady modernization of Russian businesses and business practices. (Notwithstanding that Citi believes the policy will stall, and/or that corporates will probably participate complicitly in the speculation game.)
This is a slow strategy, which could take several bull-bear cycles, and will constantly be challenged by vested interests; but theoretically, gradually increasing FX volatility should help guide the country toward a more diversified economy.
What About China?
Unlike Russia, China is a commodity importer. But, its macro perspective is similar in that it relies on a key export driver, which has now demonstrated a degree of cyclicality (manufactured exports). As we have previously seen, it is the direction of exports that will govern China’s economic dynamic in the short-medium term.
Like Russia, China understands that its economy is inefficient and would be threatened by the mass capital flows that would result from currency liberalization. But, also like Russia, it suffers from imported monetary policies (essentially due to the volatility of exports).
China could feasibly cool its economy without touching its currency rate, but it surely understands that keeping the yuan pegged is feeding vested interests, and depriving the economy of flexibility and diversity, which will make it more fragile in the future. It also threatens to unleash a wave of international trade protection that would be a graver threat than a stronger yuan. (China is most certainly symbiotically dependent on the openness of the nations it exports to.)
Thus, the gradual liberation approach appears a logical step toward full convertibility. If it comes, it will inspire urgent headlines and global excitement. Yet, it will represent a long-term strategy that will be at constant threat of reversal. It may also unleash large-scale speculative opportunities that will last until full liberation is achieved. In short, this would be a risky and uncertain policy, but, it would still represent a pragmatic step forward.
Source: Market Melange Blog
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